Investors Face Potential Municipal Bond Armageddon

The Securities and Exchange Commission is worried that municipal bankruptcies, combined with an expected spike in interest rates, means that the muni bond market could face "Armageddon," according to a report last week by SEC commissioner Dan Gallagher.

The SEC is not engaging in hyperbole but rather is simply warning of what will happen when interest rates eventually begin to rise.

The muni bond market is huge, and the vast majority of those holding the paper are individual investors, many of them retirees. Institutional investors, a.k.a. "the Smart Money," typically shun muni bonds. According to the SEC, investors have $3.7 trillion in the muni bond market and 74% of that money came from retail investors.

Commissioner Gallagher made his comments last week at an SEC-sponsored fixed income round table discussion. He was immediately attacked by those in financial services industry for making "irresponsible" comments, but his concerns are valid.

According to an InvestmentNews column by Jeff Benjamin (subscription required): "The muni bond market is quick to point out that defaults are rare and bankruptcies are even rarer. But what concerns those such as Mr. Gallagher is the trend of credit quality in the muni bond arena, combined with an environment where rates can only go up, thus driving down the value of existing bonds."

That argument is compelling. The credit quality for muni bond issuers is worsening as a general matter, Benjamin noted. "According to Moody's Investors Service, muni bond downgrades have outnumbered upgrades for 16 consecutive quarters, which is the longest period that has occurred since Moody's began tracking the data."

That sure sounds like a lot of risk for individual investors holding muni bonds, doesn't it?

Fears about munis are nothing new. Banking analyst Meredith Whitney has been warning for some time about impending bankruptcies of municipalities and the impact that would have on muni bond investors.

Any exit strategy from the muni bond market, when interest rates rise, will be very expensive and incredibly difficult.

Indeed, investors holding municipal securities could find themselves simply stuck if such a sell-off occurs. Unlike other bonds that are much more liquid-think US Treasuries or high-grade corporate debt-the municipal bond market operates under rules that are pretty much, "You buy it, you own it, good luck getting rid of it."

With interest rates at record lows, investors are seeking return and income from an ever-riskier pool of investments. Investors have jumped into muni bonds seeking higher yields than US Treasuries, and investors also like the tax benefits of most municipal offerings.

The fear is that investors may not have been told by their brokers about the "interest rate" risk and the "wipeout" risk should more municipalities file for bankruptcy, as many have already. This is what the SEC's Gallagher is getting at when he talks about "Armageddon."

Gallagher and Whitney aren't the only ones warning investors about muni bond risks. The securities industry's self-regulating entity, FINRA, issued an investor warning on the issue this past year, but it was not seen by most investors or covered by the media.

Most retail investors don't understand these risks and could get blindsided when interest rates spike, as they eventually will, causing the price of muni bonds to crater.

Investors beware. Armageddon for muni bond holders lies ahead, and it could hit you like an iceberg.

Zamansky & Associates are securities fraud attorneys representing investors in federal and state litigation and arbitration against financial institutions.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.